Fidelity offers a comprehensive instruction on How to invest tax efficiently.
Find ways to help create a strategy that defers, manages, and reduces taxes.
You may know your tax bracket. But that’s not really what you pay. In fact, the average American pays about 11% of income in federal income taxes. But that average hides a great deal of variation: Some Americans pay nothing, and others pay more than 30%.1
What determines the percentage you will pay? A lot of it is based on how much you make, but you can affect your tax bill by knowing the rules, managing how you generate income, choosing what accounts you invest in, and taking advantage of potential deductions. In general, there are three strategies you can use to try to manage your federal income taxes:
- Defer taxes with tax-advantaged accounts or investing strategies, such as 401(k)s, 403(b)s, IRAs, health savings accounts (HSAs), and products such as deferred annuities.
- Manage your tax burden by employing strategic asset location, investing in lower turnover funds, understanding mutual fund distributions, and taking advantage of charitable gifts and capital loss deductions.
- Reduce taxes now with federal-income-tax-free municipal bond income, or reduce taxes in the future with a Roth IRA or 529 college savings account.
“Taxpayers have levers they can pull to try to reduce their overall tax bill,” says John Sweeney, executive vice president of retirement income and investment insights. “By creating an investing strategy that looks at all the options, and incorporates the elements that make sense for your own circumstances and goals, you may be able to end up with a better outcome.”
Here are a few educational ideas that can help you enhance your investing strategy.
Defer taxes.
Saving for retirement is a big job. Savings accounts that offer tax advantages can help, and can be a key part of an overall tax strategy because they allow you to put off paying taxes. For savers, the key is to maximize the potential tax benefits of these accounts, if you and your adviser decide that attempting to defer taxes makes sense for you.
Take advantage of retirement accounts.
Among the biggest tax benefits available to most investors are the deferral benefits offered by retirement savings accounts such as 401(k)s, 403(b)s, and IRAs. These accounts can offer a double dose of tax advantages—the contributions you make may reduce your current taxable income, saving you cash this year, and any investment growth is tax deferred, saving you money while you are invested. In the case of HSAs, withdrawals used for qualified medical expenses could be triple tax free: tax-free contributions, earnings, and withdrawals. What's more, saving in these accounts can help lower your adjusted gross income, and that could help you avoid income limits for additional tax credits and deductions, like the student loan interest deduction or personal exemption. “That’s a reason why we think a top financial priority for most investors should be to take advantage of IRAs, 401(k)s, and other workplace saving plans,” says Sweeney.
Generally, the first step to tax-advantaged savings should be through workplace savings plans, IRAs, or both. But those accounts have strict annual contribution limit rules. If you are looking for additional tax-deferred savings, you may want to consider deferred variable annuities, which have no IRS contribution limits.
Manage taxes.
Taking advantage of tax-deferred accounts is a key step in building a tax strategy, but it’s only part of the story. You may have more opportunities for tax efficiency by being strategic about the accounts you use to hold the investments that generate the most taxes, choosing investments that may create less of a tax burden, and taking advantage of tax deductions to reduce your overall bill.
When considering taxes and investment selection, it is important to remember that old adage: Don’t let the tail wag the dog. That’s because taxes are an important factor in an investing strategy, but they certainly aren’t the only factor. The potential tax benefits of any strategy need to be viewed in the context of your overall investing plan. That said, there are some choices that can have a potential impact on your tax bill.
Match the right account with the right investment.
An asset location strategy may sound complex, and it can be, but the basic idea is straightforward: Put the investments that generate the most taxable income in accounts that provide tax advantages. Tax-efficient assets, like municipal bonds, stock index ETFs, or growth stocks you hold for the long term, may generate relatively small tax bills and may make more sense in a taxable account.
On the other hand, relatively tax-inefficient assets such as taxable bonds, high-turnover stock mutual funds, or REITs may be better kept in tax-advantaged accounts like 401(k)s, IRAs, and tax-deferred variable annuities. Of course, you also need to consider your overall asset allocation, the account rules, the potential tax implications of making changes, your investment horizon, and other factors before making any changes.
Consider investments that generate less taxes.
For taxable accounts, you want to factor in the potential tax implications of your investments. Passively managed ETFs have two major tax advantages compared with actively managed mutual funds. Actively managed mutual funds typically make more capital gains distributions than passive ETFs because of more frequent trading.3Moreover, in most cases, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, whereas index and actively managed mutual funds pass on taxable gains to investors throughout the life of the investment.
Beyond choosing between ETFs, index funds, or actively managed funds, consider a tax-managed mutual fund or separately managed account. These investments use meticulous recordkeeping of tax lots and purchase dates, gains, and losses to manage the tax exposure of the portfolio. In some cases, managed accounts may be personalized to certain aspects of your tax situation.
Keep an eye on the calendar.
Like comedy, a good tax strategy requires timing. For instance, if you are considering investing in a mutual fund for your taxable accounts, you may want to consider the distributions history of that fund. Mutual funds are required to distribute any earnings they might have realized from interest, dividends, and capital gains to their shareholders every year, and investors are likely to incur a tax liability on the distribution. It doesn’t matter whether you have owned the fund for a year or a day, if you own it when it makes a distribution, you are obligated to pay taxes. To avoid this potential tax liability, pay close attention to the distribution schedules for any funds you own—and avoid purchasing fund shares just before the distribution date.
If you are thinking of selling a fund just before the distribution, you may want to reconsider. The downside of selling funds in an attempt to avoid a distribution is that depending how much you paid for your shares, you could generate a significant capital gain—and the tax bill to go with it. So you need to factor in the potential tax impact of your decision against other criteria, including your asset allocation strategy and market outlook.
You also need to be aware of how long you hold an investment. If you sell a fund or security within one year of buying it, any gain could be subject to short-term capital gains rates, as high as 39.6% in 2013—and some high earners may be subject to the 3.8% Medicare surtax as well. You can qualify for a lower rate on gains by holding assets for over a year—the highest rate for long-term capital gains is 20%, with the possible addition of the Medicare surtax.
Offset gains and income with losses.
Tax-loss harvesting is when you sell an investment in a capital asset like a stock or bond for a loss and use that to offset gains or income. It can be a powerful way to help you keep more of what you earn. Each taxpayer is allowed to use capital losses to offset capital gains, and up to $3,000 of net capital losses to offset ordinary income each year. Any losses not used in a given tax year can be carried forward and used in future years. So selling losing investments and using those losses to offset gains can be used to reduce your tax bill. The strategy is typically most effective during volatile markets, especially during downturns.
Tax-loss harvesting may feel counterintuitive, because the goal of investing is to make money, not to lose it. But everyone experiences investment losses from time to time, and if handled properly and consistently, this strategy can potentially improve overall after-tax returns. The challenge is that a systematic tax-loss harvesting strategy requires disciplined trading, diligent investment tracking, and detailed tax accounting.
Think about charitable gifts.
Giving to charity may not be the path to greater material wealth, but the use of charitable deductions can be a powerful part of a tax strategy for those who were planning to make donations. This can help with all kinds of tax strategies, from offsetting Roth IRA conversions to complex strategies such as charitable lead or charitable remainder trusts.
One way to make the most of charitable giving is to donate securities that have increased in value. You may donate the securities directly or use a donor-advised fund—these funds let you take an an immediate tax deduction and then give you the opportunity to make grants to different charities later. Donating appreciated securities lets you avoid paying capital gains tax or the new Medicare surtax, allowing you to donate more to charity compared with selling the stock and donating the proceeds.
Many investors with stocks that have significant gains are worried about the capital gains tax bill they may see down the road. If those investors are planning to make charitable contributions, donating securities with significant capital appreciation to charity may help them reduce their capital gains tax.
Let’s look at a hypothetical example to see how. Karen has $10,000 she wants to donate to charity. She also has a few hundred shares of stock that have grown in value from $1,000 to $10,000 since she bought them. She wants to make a donation and own the stock, and is looking to maximize the tax value of her donation. Here are two options:
She could donate $10,000 in cash, and deduct $10,000 from her current income (in general, the fair market value of long-term stock donations to public charities are limited to 30% of AGI).
Or, instead of donating $10,000 in cash to charity, she could donate $10,000 of her long-term appreciated stock. The charity doesn’t pay taxes on the sale of the stock, and so they still get a donation worth $10,000. Karen still gets the $10,000 income deduction. Now Karen can use the $10,000 of cash she would have used for her donation to buy back the shares at a higher price. For example, say she sells the stock two years later for $12,000. Her basis would be $10,000, meaning she will pay capital gains taxes on $2,000 worth of gains. If she hadn’t donated the stock, her basis would have been $1,000—meaning she would pay taxes on $11,000 worth of gains. By donating and repurchasing, she was able to lower her tax bill.
Reduce taxes.
While selecting tax-efficient investments and making the most of tax-deferred accounts may help to reduce your tax bill, it won’t eliminate taxes altogether. There are a few options available that do have the potential to generate income or earnings that you generally won’t have to pay federal income taxes on—including many municipal bonds, Roth IRAs, and college savings accounts.
Research tax-exempt municipal bonds.
With many muni bonds, whether you’re purchasing individual securities directly or through a fund, ETF, or separately managed account, you generally get federally tax-exempt income. What’s more, in many states, these bonds offer state tax–exempt income, too. That covers most municipal bonds but doesn’t apply to all municipal bonds, many private activity bonds, Build America Bonds, and other exceptions.
When considering munis, it is important to note that the yield is typically lower than taxable bonds with similar credit ratings and maturity. A lower yield means they will have a higher duration, all else being equal, and and a higher duration means the bond may be more volatile in a rising interest rate environment. It also means that your tax bracket is a key factor to consider when evaluating a muni bond, along with traditional bond characteristics such as yield, maturity, and credit quality. The basic rule of thumb is that investors in higher tax brackets will be more likely to benefit from investing in munis.
When considering munis, it is important to note that the yield is typically lower than taxable bonds with similar credit ratings and maturity. A lower yield means they will have a higher duration, all else being equal, and and a higher duration means the bond may be more volatile in a rising interest rate environment. It also means that your tax bracket is a key factor to consider when evaluating a muni bond, along with traditional bond characteristics such as yield, maturity, and credit quality. The basic rule of thumb is that investors in higher tax brackets will be more likely to benefit from investing in munis.
Consider a Roth or Roth IRA conversion.
Instead of deferring taxes, you may want to accelerate them by using a Roth account. A Roth IRA contribution won’t reduce your taxable income the year you make it, but there are no taxes on any future earnings as long as you hold the account for five years and are age 59½ or older, disabled, or deceased, or withdraw earnings to pay for qualified first-time homebuyer expenses. That can make a big difference if you think your tax rate will be the same or higher than your current rate when you withdraw your money. There are also no minimum required distributions (MRDs) from a Roth IRA during the lifetime of the original owner.
Roth IRA contributions are only allowed for investors up to a certain income level, but those rules don’t apply to Roth 401(k)s, if your employer offers you one. Higher wage earners can also access a Roth through a conversion from a traditional IRA or 401(k). You pay federal income taxes now on the conversion amount but none on any future earnings—if you meet the requirements.
Seek tax advantages for college.
The cost of higher education for a child may be one of your biggest expenses. Like retirement, there are no shortcuts when it comes to saving, but there are some options that can reduce your taxes. For instance, 529 college saving accounts and Coverdell accounts will allow you to save after-tax money but get tax-deferred growth and tax-free withdrawals when used for qualified expenses. Grandparents can also make significant gifts to a 529 without incurring gift taxes. You may also want to consider EE savings bonds or prepaid tuition plans, which offer other tax advantages when saving for college.
Put a strategy into place.
There are lots of tax moves an investor can make. The key is to pull together a number of different strategies that make sense for your situation. Then be disciplined about sticking with your approach—either on your own, with a financial adviser, tax adviser, or with a professional money manager. Some people don’t want to spend any more time thinking about taxes than is absolutely necessary, but spending a little time assessing your situation and your options may help you keep a bit more of your money in your pocket.
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